As Japan seeks revival, hedge funds bet on a bust

In this Wednesday, June 5, 2013 photo, Takashi Yamada, right, a government-bond trader at major brokerage Daiwa Securities Co., monitors screens at his bond trading section in Tokyo. Until a couple of months ago, Yamada had one of the most genteel jobs in Japan. Now, his days are so harried he doesn't have time to eat lunch. Shock-and-Awe monetary policies, announced in April, have sent Japanese government bonds, this nation's equivalent of U.S. Treasurys, into a whirl of volatility. (AP Photo/Shuji Kajiyama)

TOKYO (AP) -- Until a couple of months ago, Takashi Yamada had one of the most genteel jobs in Japan. Now, his days are so harried he doesn't have time to eat lunch.

Yamada, 45, is a government-bond trader at major brokerage Daiwa Securities Co.

Shock-and-Awe monetary policies, announced in April, have sent Japanese government bonds, this nation's equivalent of U.S. Treasurys, into a whirl of volatility.

"Our job is about interest rates, and that's supposed to be like rice in a meal, not steak, something basic but needed," Yamada said, looking weary and a bit out of breath, after nonstop juggling of bond selling and buying on several monitors at his desk. "No one expected this."

The sudden frenzy of his job underlines the growing fears about Japan's surging public debt. Bonds were long stable, which meant the adjustments to bond trades or "positions" Yamada had to do were routine and predictable. Not anymore.

The yield, or interest rate, on benchmark 10-year bonds shot up to 1 percent for the first time in a year late last month, although it later headed down. In the bond market, yields go up when prices drop so even tiny moves in those rates can translate into lots of yen made or lost.

The lavish Japan revival policies of Prime Minister Shinzo Abe, including the Bank of Japan's doubling the money supply in two years, are designed to wrest the nation out of deflation, or continually sinking prices that hurt growth, and two decades of economic doldrums.

But at the heart of "Abenomics" is a contradiction: Japan may not be able to afford the inflation that Abe's grand ambition hopes to ignite.

After years of deficits financed by sales of government bonds, public debt is already twice the size of the economy and interest payments consume a quarter of government spending. It is an unassailable reality that if inflation goes up so must interest rates and so must pressure on the bloated finances of a government atop the world's third-largest economy.

Although Abenomics has generally lifted Tokyo stocks and lowered the yen, a boon for the giant exporters of Japan Inc., the bond market that keeps Japan's government afloat is growing ever nervous.

The sell-off in bonds last month was one sign of the panicky mood and occurred despite the Bank of Japan's constant presence in the market, buying up more than half of government bonds for the next two years.

A handful of overseas hedge funds are seeking to make a killing on the gloomiest scenario for Abenomics. Experts say their methods involve futures trading, which allows betting on bonds you don't own.

They are counting on what they see as an inevitable catastrophe. If bond prices crash, their owners, mostly Japanese financial situations, will lose a major chunk of their assets overnight. It would freeze up the market that funds the government's mammoth deficits, shattering Japan's credibility as an economic power and send shockwaves rippling around the world.

"My assessment of the situation is that nothing can be done from this point forward to avoid a full bond crisis," said J. Kyle Bass, managing partner at Dallas-based Hayman Capital Management. "I think it is not only possible. It is probable."

His hedge fund invests in conventional ways, too, such as stocks, although none in Japanese equities, and currencies, including investing in a cheaper yen. But he has made positions that will allow his hedge fund to come out ahead if Japanese bond prices plunge. He declined to give details of how he hedges, citing policy.

Investors such as Bass are sometimes criticized as seeking to make money off a crisis or even helping to engineer one. The way Bass sees it, his hedge fund is carrying out an investment strategy that's prepared for the obvious risks.

"The better way to ask the question is: How do you hedge yourself against this eventuality?" Bass said in a recent interview in Tokyo.

He may be on to something.

The risks for investing in bonds tend to be minimal compared with stocks and currencies. But the rewards for betting on a bond crash can be great — although that's a big "if."

After Abe took office late last year, the Bank of Japan set a 2 percent inflation target and the government promised structural reforms such as opening up trade, promoting women in the work place and boosting people's income. The government is pumping 8 trillion yen ($80 billion) into public spending, focused on infrastructure, to jump-start the economy.

The economy grew a healthy 4.1 percent in the last quarter, and hopes are high revival will continue — a reversal that would be remarkable, following years of contraction and shaky growth.

It's too much to believe for some.

The recent gyrations in bonds may have been "something closer to a realization that for all the brouhaha of Abenomics ... the Japanese financial authorities are losing the plot," said Jonathan Rogers, a senior credit analyst for bond investing bible IFR Asia in a recent column.

He said it may have been better for Japan to continue to muddle along. A rapidly aging society is shrinking tax revenue while lifting pension, health care and other social costs in coming years. Yet until the advent of Abenomics, the Japanese bond market had been stable with virtually no fear of a sell-off.

Unlike other countries, the bonds are almost all owned by Japanese, mostly megabanks and other major financial institutions. Only 8.7 percent is held by overseas investors, according to the Bank of Japan.

As a result, fears about a bond collapse have long been brushed off as overblown.

Some analysts insist it will never happen. They say it's impossible for confidence in Japan to be shaken, which is what a bond collapse would signify.

The government is planning to raise sales taxes to boost revenue. Japan could start growing robustly again, solving its problem once and for all.

Defenders of Japan's strengths also point to its giant foreign currency reserves, much of them held as U.S. Treasurys, and its long record of trade and investment surpluses with the rest of the world. Those strengths have weakened recently as Japan's trade balance has sunk into the red.

Takuya Kanda, analyst at Tokyo research institute Gaitame.Com, believes the recent bond jitters were set off because only a tiny proportion of bonds are actively traded and so a slight reaction to Abenomics has major impact.

"It's the old whale-in-the-pond phenomenon," he said.

Mainstream Japanese investors share an understanding that they must hang on to their bond savings "out of patriotism," Kanda said.

But he noted Japan may be borrowing beyond what common sense would dictate as normal.

"No one can say it's 100 percent safe," said Kanda. Stocks may be safer than bonds these days, he said.

Doomsayers, like Takeshi Fujimaki, a consultant and former Morgan trader, have been warning about a bond nose-dive for years.

He said he dreads the day he might be vindicated and hopes his warnings will be heeded.

The argument goes like this: Inflation proves a plus only for debtors. Rising prices, by definition, will bring down the value of debts. The biggest debtor of all is no one but the government. Yet solving its debt problem through inflation wreaks havoc on the banks and pension funds that bought government bonds. And if inflation spiraled out of control in what Fujimaki calls "hyperinflation," skyrocketing prices would send many people into instant poverty.

Fujimaki, who has written books on his fears, including his latest titled "Helpless Japan," advises everyone to turn their assets into dollars.

"It can come any day, even tomorrow. The balloon of bad debt is already inflated to its limit," he said.